What do people actually know about personal finance?
Not much, it seems...

Saturday, March 1, 2008

Where does illiteracy hurt?

While the low levels of financial literacy discussed in my previous blogs are troubling in and of themselves, what is most important are the potential implications of financial illiteracy for economic behavior. One example is offered by an article Hogarth, Anguelov, and Lee published in 2005, that demonstrates that consumers with low levels of education are disproportionately represented amongst the “unbanked,” those lacking any kind of transaction account.

To examine how financial illiteracy is tied to economic behavior, Olivia Mitchell (Wharton School) and I used the questions we have devised for a special module for the 2004 Health and Retirement Study, and linked financial literacy to retirement planning. We found that those who are more financially knowledgeable are also much more likely to plan for retirement. Specifically, planners are most likely to know about interest compounding, which is clearly a critical variable to devise saving plans. Even after accounting for several demographic characteristics, such as education, marital status, number of children, retirement status, race, and sex, we still found that financial literacy plays an independent role: Those who understand compound interest and display basic numeracy are much more likely to have planned for retirement. This is important, since lack of planning is tantamount to lack of saving.

Other authors have also confirmed the positive association between knowledge and financial behavior. For example, in a paper jointly written with Maarten van Rooji and Rob and Alessie, we find that respondents who are more financially sophisticated are more likely to invest in stocks. John Campbell, from Harvard University, in his article published in the Journal of Finance in 2006 has highlighted how household mortgage decisions, particularly the refinancing of fixed-rate mortgages, should be understood in the larger context of ‘investment mistakes’ and their relation to consumers’ financial knowledge. This is a particularly important topic, given that most US families are homeowners and many have mortgages. In fact, many households are confused about the terms of their mortgages. Campbell also finds that younger, better-educated, better-off white consumers with more expensive houses were more likely to refinance their mortgages over the 2001-2003 period when interest rates were falling.

His findings are confirmed by Brian Bucks and Karen Pence, from the Board of Governors, who examine whether homeowners know the value of their home equity and the terms of their home mortgages. They show that many borrowers, especially those with adjustable rate mortgages, underestimate the amount by which their interest rates can change and that low-income, low-educated households are least knowledgeable about the details of their mortgages.

Further evidence of biases is provided by Victor Stango and Jonathan Zinman from Dartmouth College, who thoroughly document the systematic tendency of people to underestimate the interest rate associated with a stream of loan payments. The consequences of this bias are important: Those who underestimate the annual percentage rate (APR) on a loan are more likely to borrow and less likely to save.

1 comment:

"You have made an important comment about the linkage between financial literacy and long-term planning. I find that those who dig a deep financial hole for themselves, whatever their level of income, education, family background, or social standing, make a number of mistakes which all relate to failure to think through the longer-term consequences of their actions. I have found that those who try to get rich quick invariably fail to understand that schemes that produce a high and quick return also produce a high risk, which means that the investor can lose everything.

I have also found that people do not understand that, even when they do not realize a total return on longer-term actions, there is almost always some compensating short-term benefit. For example, some of our less successful sales professionals at my company are always trying for the quick victory, but neglect the longer-term relationship-building that promises big payback because it is perceived to take too long. Those who invest in longer-term relationship building not only get the big long-term order, but, as time goes on, they capture smaller unanticipated opportunities, and they learn about other big opportunities that would never have fallen in their lap had they just gone for the quick, big order.

The other attribute of financial literacy is the recognition that, almost always, if there is a big opportunity in a well-publicized space, everyone will compete for that opportunity, and, in effect, build up the cost. For example, a "hot" stock recommended by a well-known broker will draw many buyers into the stock and cause everyone to pay more than they would have otherwise paid.

I believe that we should have a class in all of our schools to teach our children some basic life skills on how to budget, how to spend money intelligently, and how to invest. Thank you again for a thoughtful post."

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About Me

Annamaria Lusardi is the Denit Trust Distinguished Scholar and Professor of Economics and Accountancy at the George Washington School of Business. Previously, she was the Joel Z. and Susan Hyatt Professor of Economics at Dartmouth College. She has taught at Dartmouth College, Princeton University, the University of Chicago Public Policy School, the University of Chicago Booth School of Business and the Graduate School of Business at Columbia University. From January to June 2008, she was a visiting scholar at Harvard Business School. She has advised the U.S. Treasury, the U.S. Social Security Administration, the Dutch Central Bank, and the Dartmouth Hitchcock Medical Center on issues related to financial literacy and saving. She is the recipient of the Fidelity Pyramid Prize, awarded to authors of published applied research that best helps address the goal of improving lifelong financial well-being for Americans. She holds a Ph.D. degree in Economics from Princeton University.